From QI to “like kind” to boot, there is a lot of jargon that is used when executing an Internal Revenue Code Section 1031 Exchange. If it doesn’t make a lot of sense to you, that’s okay; you’re in the majority. We’re going to take a brief look at a few different examples of 1031 exchange boot in this article and how it’s an important term to understand when you’re considering a tax deferred exchange.
What is a 1031 Exchange Boot?
Firstly, let’s review the definition of 1031 exchange. A 1031 exchange allows resident and non-resident United States federal taxpayers to defer capital gains and recaptured deprecation taxes when exchanging real property held for productive use in a trade, business or for investment for like-kind real property held for productive use in a trade, business or for investment. The tax otherwise paid in a traditional sale is deferred indefinitely until the replacement property is sold or another 1031 exchange is initiated. Why would you want to do this? A 1031 exchange gives you the opportunity to utilize funds that would be otherwise unavailable for the acquisition of new investment or business-related real property. Think of it as an interest free loan from the US government.
One of the primary requirements in a 1031 exchange is that in order to fully defer all capital gains taxes and depreciation recapture due, the equity and debt in the replacement (new) property must be equal to or greater than the equity and debt of the relinquished (old) property. Bearing in mind that a partial exchange is possible where the debt and equity is not replaced, the vast majority of Exchangors are executing 1031 exchanges with the intent of fully deferring the taxes due.
By not fully replacing the equity or debt in your replacement property, you would trigger a taxable consequence on the underutilized funds known as Boot. Though there are multiple types of boot, the most common are mortgage boot and equity boot.
What is Mortgage Boot?
Mortgage Boot occurs when the property you acquire has mortgage debt less than the property you relinquished. For example, if you sold an investment property for $300,000 and it had a mortgage worth $125,000 that was paid off at closing and your new replacement property mortgage is only $100,000, you would be subject to taxation on the $25,000 difference. The simplest way to avoid this is to be aware of what your debt requirement is from the beginning and factor it into the replacement property you’re acquiring. One unique aspect of mortgage debt is that it can be offset by additional cash, meaning in the previous scenario, if you were to bring $25,000 worth of non-exchange related funds to the closing, it would satisfy your obligation. Cash can offset debt, debt however cannot offset cash.
What is Equity Boot?
Equity or Cash Boot occurs when equity, cash or any cash equivalent received as part of the sale of the relinquished property is not replaced fully in the replacement property. In some instances, Exchangors will receive equity at the closing of their relinquished property as part of their overall strategy; the portion received is subject to taxation and is considered Equity or Cash Boot. For example, if you sold your investment property for $300,000 and paid off the $125,000 mortgage, after closing costs you would determine your net sales proceeds. Let’s say that the net sales proceeds for this sale are $150,000. The Exchangor is welcome to receive any portion of those funds at closing, but by receiving them will trigger a taxable consequence. Keep in mind that the more funds received reduces the benefit of the 1031 exchange and could potentially render the 1031 exchange useless. Being aware of these common types of boot from the onset of your exchange will help you determine if you want to strategically utilize boot or avoid it at all costs in your 1031 exchange. Once your relinquished property sells, it is a best practice to review the equity and debt requirements with your Qualified Intermediary so that you’re well aware of what needs to be reinvested in the replacement property.
Atlas 1031 Exchange has been accommodating tax deferred exchanges of all kinds for more than 16 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange whether you want to receive boot or avoid it at all costs. Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the form.
